Passive Activity: Material Participation Tests

In years past, the wealthy greatly reduced their taxes by investing in tax shelters that had no economic value, but were simply used to generate large tax deductions that often exceeded their actual investment. A common characteristic of most of these tax shelters was that the taxpayer did not materially participate in the activity. Hence, the Internal Revenue Service (IRS) promulgated rules that limited deductions in these so-called passive activities by limiting the deductibility of passive losses to passive income. Thereafter, these taxpayers tried to circumvent the rules by either classifying their activities as active or passive, depending on what other active or passive income or losses they had. Consider these examples:

Example 1: John works as a self-employed doctor, who earned $300,000 for the tax year from his medical practice, but he also has a $120,000 loss from another activity that he invested in. If it was an activity that he materially participated in, then he can deduct the full $120,000 from his $300,000 earned from his medical practice. However, if the activity was passive, and he has no other passive income, then he cannot deduct any of the $120,000 loss for that tax year.

Example 2: On the other hand, Amy has $100,000 of income from a passive activity and a loss of $50,000 in which she participated minimally. Since Amy has no other income for the tax year, she can only deduct the $50,000 loss if she can classify it as a passive activity. Hence, she may classify it as a passive activity to deduct the loss.

As can be seen from the above 2 scenarios, taxpayers will classify their activities as active or passive, depending on which yields their greatest tax benefit. To prevent this classification according to tax needs, the IRS set specific rules for classifying activities. The key distinction between active and passive income is the amount of material participation by the taxpayer. Obviously, active income results from actively participating, such as working at a job or conducting a business, especially a business providing personal services.

Definition of Participation

Although IRC §469 defines material participation as participation on a regular, continuous, and substantial basis, the IRS has decided that those terms are not concrete enough to provide a bright-line distinction between active and passive activities.

The IRS defines participation as being any work that an owner of a business would typically do. If the work is not typically done by an owner, and if the work was done to avoid the passive loss rules, then the activity will not be deemed to be material participation. For instance, owners would not typically be doing janitorial work, so any such work being done by an owner would be viewed suspiciously in an IRS audit. Material participation also does not include work that would ordinarily be performed as an investor, such as the reviewing of financial reports, where the objective is to review profitability rather than managing the business.

§469 also defines participation to include participation by the taxpayer's spouse. So if the taxpayer owns a store, and his wife works in it full-time, then that would satisfy the active participation test. According to the IRS, these also indicate active participation:

And that these indicate passive participation:

Participation is generally proved by any reasonable method, usually by contemporaneous daily records, such as appointment books, calendars, or other records.

Special rules, which are not discussed in this article, apply to certain retired or disabled farmers.

Material Participation Tests

The IRS has devised 7 tests for classifying activities. Material participation is satisfied if any of the 7 tests are satisfied. The 1st 4 tests are based on current participation, while 2 of the tests are based on prior participation in the activity. The final test depends only on facts and circumstances of the activity.

Tests Based on Current Participation

Test 1: Does the taxpayer participate in the activity for more than 500 hours during the tax year? The 500-hours rule prevents most from treating income from a passive investment as active income since 500 hours requires substantial effort and time, which few would be able or willing to accomplish, especially if they were working at a job or an active business.

Test 2: Does the participation of the taxpayer constitute substantially all the participation for that activity, including non-owner employees? The idea behind this test is that if the taxpayer is doing most of the work for the activity, then it is an active business that may not require 500 hours, and so should be classified as active income. On the other hand, if the business had non-owner employees doing most of the work, then it is questionable whether the taxpayer's participation was necessary, that it was just a means to classify the passive activity as active.

Test 3: Does the taxpayer spend more than 100 hours in the activity, which is more than the participation of any other individuals? Although 100 hours is certainly less than the 500 hours of Test 1, it is reasonable that if the taxpayer participates at least as much as anyone else, then his participation is material.

Test 4: Does the taxpayer's aggregate participation in other activities exceed 500 hours, where the taxpayer has at least significant participation in each activity? The IRS defines significant participation activity as one in which the taxpayer is active for more than 100 hours during the tax year. Therefore, to satisfy Test 4, the taxpayer must have several activities where she spends more than 100 hours actively participating in the activity and where the sum of those hours exceeds 500. If the taxpayer spends 100 hours or less in a given activity, then none of the hours in that activity is counted toward the 500.

Tests Based On Prior Participation

In Tests 1-4, the IRS is trying to prevent classifying passive activities as active. In Tests 5 and 6, the IRS is trying to prevent classifying active income as passive income so that passive losses can be deducted from it. The IRS presumes that if the taxpayer materially participated in an activity in the past, then she will continue to do so. Hence, changing what was once an active activity into a passive activity is presumed trying to classify active income as passive income to deduct passive losses.

Test 5: Did the taxpayer materially participate in any 5, not necessarily consecutive, of the previous 10 tax years? If so, the activity is classified as active.

Test 6: If the activity was a personal service activity, was the taxpayer active in the same activity during any of the 3 preceding taxable years? If so, then, again, the activity is considered active. A personal service activity includes the performance of personal services in accounting, actuarial science, architecture, engineering, health (including veterinary services), law, performing arts, consulting, or any other business where capital is not a big income-producing factor.

Participation That Is Regular, Continuous, and Substantial

Test 7 falls back on the definition provided by §469 that the activity be done on a regular, continuous, and substantial basis, which, according to the IRS, must exceed 100 hours of activity by the taxpayer. Management of the activity is not included if there is someone else actually managing the activity, is compensated as a manager, or spends more time managing the activity than the taxpayer. This rule is designed to prevent taxpayers from coming in for 101 hours to manage the business so that the activity can be classified as active, even though there is a full-time manager for the business.

Limited Partnerships

A limited partnership consists of at least 1 general partner who has unlimited liability for the debts of the partnership and one or more limited partners whose liabilities are limited to their investment. A limited partner is only considered a material participant if Tests 1, 5, or 6 are satisfied, meaning that the limited partner must either spend more than 500 hours in the activity or must have been active in the activity in previous tax years. However, a general partner only needs to satisfy any of the 7 tests.

Passive Activity Rules For Personal Service Corporations And Closely Held C Corporations

To prevent individuals from bypassing the passive activity rules by using corporations, tax law imposes a material participation test for personal service corporations and closely held corporations. A personal service corporation has these characteristics:

Employee-owners of a personal service corporation satisfy the material participation test if 20% of the corporation's compensation for the services is performed by employee-owners who owned more than 10% of the corporation at the end of the prior tax year.

A closely held corporation is not a personal service corporation, and is one in which 5 or fewer individuals own, directly or indirectly, more than 50% of the corporation sometime during the last 6 months of the tax year. Corporations satisfy the participation test, if one or more individuals, who own more than 50% of the corporation, materially or significantly participated in the activity. The material participation test is also satisfied if, during the entire 12-month tax year, at least one full-time manager and at least 3 full-time employees, none of whom owned more than 5% of the stock, materially participated in the activity, and business deductions resulting from the activity exceed 15% of gross income. Unlike for individuals, closely held corporations can use passive losses to offset active income but not portfolio income.

Form 8810, Corporate Passive Activity Loss and Credit Limitations is used by personal service corporations and closely held corporations to determine their passive activity loss or credit.